For the equity holder, the source of future cash flows is the earnings of firms.
Earnings create value for shareholders by the :
- Payment of cash dividends
- Repurchase of shares
- Retirement of debt
- Investment in securities, capital projects, or other firms.
If a firm repurchases its shares, it reduces the number of shares outstanding and thus increases future per-share earnings.
If a firm retires its debt, it reduces its interest expense and therefore increases the cash flow available to the shareholders.
Finally, earnings that are not used for dividends, share repurchases, or debt retirement are retained earnings. These may increase future cash flows to shareholders if they are invested productively in securities, capital projects, or other firms.
Which creates more value?
Cash dividends: Some argue that shareholders most value stocks' cash dividends. But this is not necessarily true. In fact, from a tax standpoint, share repurchases are superior to dividends. Cash dividends are taxed at the highest marginal tax rate to the investor; share repurchases, however, generate capital gains that can be realized at the shareholder's discretion and at a lower capital gains tax rate.
Share repurchases: Recently, there have been an increasing number of firms who engage in share repurchases. The shift from dividends to share repurchases is one factor that has raised the valuation of some equities.
Debt repayment: Others might argue that debt repayment lowers shareholder value because the interest saved on the debt retired generally is less than the rate of return earned on equity capital. They also might claim that by retiring debt, they lose the ability to deduct the interest paid as an expense. However, debt entails a fixed commitment that must be met in good or bad times and, as such, increases the volatility of earnings that go to the shareholder. Reducing debt therefore lowers the volatility of future earnings and may not diminish shareholder value.
Reinvestment of earnings: Many investors claim that this is the most important source of value, but this is not always the case. If retained earnings are reinvested profitably, value surely will be created. However, retained earnings may tempt managers to pursue other goals, such as overbidding to acquire other firms or spending on perquisites that do not increase the value to shareholders. Therefore, the market often views the buildup of cash reserves and marketable securities with suspicion and frequently discounts their value.
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Fear of misusing retained earnings
If the fear of misusing retained earnings is particularly strong, it is possible that the market will value the firm at less than the value of its reserves. Great investors, such as Benjamin Graham, made some of their most profitable trades by purchasing shares in such companies and then convincing management (sometimes tactfully, sometimes with a threat of takeover) to disgorge their liquid assets.
Why management would not employ assets in a way to maximise shareholder value, since managers often hold a large equity stake in the firm? The reason is that there may exist a conflict between the goal of the shareholders, and the goals of the management, which may include prestige, control of markets, and other objectives. Economists recognise the conflict between the goals of managers and shareholders as AGENCY COST, and these costs are inherent in every corporate structure where ownership is separated from management.
Payment of cash dividends or committed share repurchases often lowers management's temptation to pursue goals that do not maximise shareholder value.
In recent years, dividend yields have fallen to 1.5%, less than one-third of their historic average. The major reasons for this are the tax disadvantage of dividends and the increase in employee stock options, where capital gains and not dividends figure into option value. Nevertheless, dividends historically have served the function of showing investor that the firms' earnings were indeed real.
Recent concerns about aggressive accounting policies and the integrity of earnings following the Enron debacle may bring back this once-favoured way of delivering investor value.
Ref: Stocks for the Long Run, Jeremy Siegel
